Proof of Stake – How does it work and what are the advantages?

Sep 19, 2014

Recently more and more alt coins have decided to integrate a proof of stake system over the traditional proof of work system used by Bitcoin and Litecoin. But why, one may ask? Frankly, the proof of work system is not perfect. A cryptocurrency without proof of stake doesn’t just lack an incentive for users to continue holding on to their coins, but is also susceptible to a 51 percent attack if one party controls a majority of the total mining output. To solve help these problems, some cryptocurrencies, such as NXT, have implemented a 100 percent proof of stake system. Other currencies, such as Dogecoin, have implemented elements of proof of stake to take advantage of its benefits.

What is Proof of Stake?

Like a proof of work system, proof of stake allows miners to verify block chain transactions and solve puzzles in order to receive rewards – which ultimately are the coins you receive. In a proof of work system, miners complete difficult puzzles using the hashing power of their computer equipment and are rewarded based on how quickly they can solve the mathematical puzzles. The faster the hashrate, the more coins they will receive. Mining in a proof of stake system however is not completely determined by one’s hashrate (or computing power,) but instead by how much of the currency they currently own. If someone owns five percent of the currency, then they can mine five percent of the blocks.

In proof of stake the “mining” that goes on doesn’t necessarily refer to the mining done on currencies such as Bitcoin with powerful computing equipment. Instead, “mining” occurs when transactions take place within the currency, generating fees. These fees are more likely to go to the users with greater stakes in the currency. This creates an incentive for miners to hold onto their coins instead of trading them away as soon as they’re earned.

How proof of take can solve the flaws of proof of work

Although more merchants are accepting Bitcoin, the price has yet to recover from its peak late last year. Though there are many reasons for this, one in particular is because most of these merchants convert their Bitcoins into dollars or other fiat currencies as soon as they earn them. This creates a downward pressure on the price of Bitcoin due to the constant selling of currency that exist the Bitcoin economy. In the proof of work system there is no incentive for merchants to keep Bitcoins and due to its volatile nature many merchants are scared to hold them for longer periods of time. The proof of stake system however gives people an incentive to keep their coins rather than selling right away.

Proof of stake can also solve the very critical risk of 51 percent attacks that haunt both the Bitcoin and other cryptocurrency community. Earlier this summer the Ghash.io pool, controlled by CEX.io, came dangerously close to reaching the 51 percent attack potential. While the company did eventually reduce its network hashing rate and issued a press release noting its intentions to prevent a 51 percent attack, proof of stake would permanently prevent this issue from ever occurring. This is because it is not only very difficult to attain, but would do more harm to the causer of the 51 percent attack than to the rest of the network.

The advantages of a mix of both systems

The proof of stake system is by no means perfect. By giving people an incentive to save their coins it also gives them an incentive to hoard and never spend any coins. This in turn lowers the overall transaction volume, which can hurt the price of the currency as well. Ultimately there must be a healthy median between these two systems that minimizes the flaws of both and maximizes their advantages. But will a currency like Bitcoin ever adopt a proof of stake system? Probably not. This is because changing anything in the Bitcoin protocol as dramatic as a new proof of stake system would make the currency seem weak and unguided. But it is very likely in the future that other currencies will adopt a mixed system between the two methods, much like Dogecoin.